October 2, 2012 8:45 pm

Derivatives: Sophisticated market drives liquidity

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BM&FBovespa, the leading exchange in Latin America©Bloomberg

Bovespa could see record total of first-half offerings

With Brazil’s equities and its currency, the real, out of favour for most of 2012 – hurt by a combination of lacklustre economic growth and a jump in global risk aversion – the country’s derivatives market has remained a driver of liquidity.

Almost 476m derivatives contracts were traded on the BM&FBovespa, Latin America’s leading exchange, in the first eight months of the year compared with 451m contracts in the same period of 2011.

In August, more than 60m contracts worth $2tn were negotiated even as volatility in global markets increased ahead of a key US Federal Reserve meeting in September, and the local currency accumulated a 9.8 per cent decline for the year.

That turnover is also noteworthy because it dwarfs the roughly $82.4bn traded in Brazilian equities during the same month, a reminder that when investors “bet” on Brazil, they are mainly doing it through the country’s derivatives’ market.

Latin America’s largest derivatives market has long been a favourite for investors, such as hedge funds and investment banks, which use it mostly to make money from the difference between Brazil’s benchmark interest rates and those in developed markets.

It is also chiefly through derivatives, that investors can place bets on the real, one of the most actively traded emerging market currencies.

Win Thin, an emerging market strategist at Brown Brothers Harriman in New York, says: “Brazil’s derivatives market is very sophisticated and has been historically a driver of liquidity, being a venue for currency-, interest rate- and exports-related contracts.”

First designed in the late 1970s, Brazil’s derivatives market catered to commodities products in response to the country’s profile as a natural resources and agribusiness powerhouse. That original make-up has changed and now foreign exchange and interest rate futures are the bulk of all derivatives traded.

The biggest participants are institutional investors and banks, accounting for 68 per cent of trading, says BM&FBovespa. But in recent years, that share of foreign participants has risen steadily and jumped from 16 per cent last year to 25 per cent in 2012.

The popularity of Brazil’s derivatives market can be explained in part by its focus on exchange traded products: about 90 per cent of all contracts are traded and cleared via a central counterparty, BM&FBovespa itself.

Over-the-counter products are registered mainly through Cetip, Latin America’s largest depositary of private fixed-income securities. BM&FBovespa and Cetip monitor daily trading to prevent risk from building up, and trades are settled the same day.

This breakdown is not widespread in most global markets, where over-the-counter products dominate. Brazilian regulations are tight and only institutions accredited by the central bank can perform transactions.

“Our structure is particular, and in our experience, it’s very efficient,” says Fabio Dutra, BM&FBovespa’s director for fixed-income, foreign exchange and derivatives. “This integrated model is becoming a reference for other global and foreign regulators in particular, because it minimises systemic risks. It is one of the reasons this market has managed to weather the increase in global volatility that we’ve seen since the financial crisis.”

But while centralisation of trading minimises risks, some participants say the lack of competition pushes up costs and limits the pool of products.

Other global exchanges, such as BATS Global Markets, have tried to set up alternative trading venues in the country. In one example, ICE – the US futures operator – bought a 12.4 per cent stake in Cetip for about $521m last year.

Entrants would be required to do both trading and clearing, setting up the infrastructure for both activities.

Some analysts note that many local brokers worry that any potential change in the derivatives market configuration could demand further investments in telecommunication and information technology, at a time when volumes remain depressed under the current global scenario.

For now, as the threat of competition grows, the exchange is accelerating moves to lower fees and broaden its derivatives portfolio. After launching a soyabean contract and eight currency derivatives in 2011, the exchange is rolling out a cross-listings of the Ibovespa index futures – in partnership with the US CME Group. S&P 500 futures will also be traded in Brazil on the BM&FBovespa. And the exchange is considering adding fixed-income exchange traded funds and real estate-backed contracts.

“In order to deepen this market and attract a broader group of investors, it is important to diversify the pool of products,” says Mr Dutra. “Some of our biggest efforts and investments are geared towards to that end.” Still, one area that raises concerns among investors, brokerages and the exchange alike is government intervention on financial markets.

In recent years, Brazil has introduced several taxes on international financial transactions seeking to slow speculative inflows and damp rapid currency gains. Moves included a levy on foreign exchange derivatives to discourage long bets on the real.

But also discouraging has been the performance of the real. The currency has declined about 23 per cent since hitting a cyclical high in late July 2011, in part as a result of a series of benchmark rate cuts promoted by the central bank to stimulate growth.

Changes in the exchange rate affect the derivatives markets in particular, because trading in interest rate and real futures account for more than 50 per cent of all derivatives contracts in Brazil. It is also through derivatives that Brazilian exporters hedge their currency receivables.

Mr Dutra says: “While we see the positive long-term effect of government policies, as an exchange, we have to acknowledge their impact on our markets. For instance, we’ve seen migration of foreign investors out of Brazil exchange rate derivatives in response to government controls.”

Still, in the long run, analysts say the outlook for Brazil’s derivatives markets remain solid. They also note that with the country’s large pipeline of infrastructure projects and anticipated expenditures in preparation for the 2014 World Cup and the 2016 Olympics, the derivatives market may provide an attractive source of hedging for investors, as both private and government debt-issuance is likely to increase in coming years.

Mr Thin says: “It’s a fine balance trying to develop capital markets, deepen and open the investor base while keeping tight control of money flows in and out of the country.

“The Brazilian government can be blunt at times and some of its policies have affected certain groups of investors,” he adds. “But Brazil is far from being unfriendly to foreign investors and most have managed to adjust to the increase in regulations and taxes. Ultimately, this is a market that will only keep growing.”

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